Using Technical Analysis to Reduce Risk

One of the most important investing tools you have is your stop loss. In market times that are as tough as the ones we’ve been experiencing, having a good defense is essential to your financial health. A good defense makes for a good offense.

 

The shields of Gondor.

When you make an investment you either begin making profit on it or you begin taking a loss on it. Let’s assume you made a $1,000 investment. A 10% gain on that investment means you would make $100, while a 10% loss means you would lose $100. You either gain or lose $100, so what’s the big deal? Now let’s assume with the remaining $900 of your initial investment, you earn 10%. But you only had $900 this time, so you gain $90 instead of $100. If you had gained $100 first then lost 10%, you would also have $990.

 

If instead of a 10% loss, you took a 20% loss on your initial $1,000 investment, then you’d end up with $800. An equivalent gain to earn back your $200 is now 25% and an equivalent 20% gain would only earn you back $160 of your initial $200 loss. You’re out $40, an increase of four times while your losses only doubled.

 

A 50% loss is where it gets interesting, because if you’ve lost 50% on your investment, you must make a fully doubled 100% to get your money back. An equivalent return of 50% profit after 50% of losses is only $250. Now you’re out $250, and not only that, but you’ve had to work a lot harder to just do that (earning 50% ROI). See the chart below:

 

 

 

Starting Position % Lost % To Recover Loss Amount Lost $ Remainder $
$1,000 8 8.7 80 920
10 11.1 100 900
20 25.0 200 800
30 42.8 300 700
40 66.6 400 600
50 100 500 500

 

 

An 80% loss on investment means you’d need to earn 500% in order to just get back to even. This is why you should cut your losses before this point. You must use your defense. In short, you must survive. You can’t play in the game again unless you keep the Jacksons, Franklins, and McKinleys – the players. This is how panics happen. Investors have held on way past the appropriate amount they should risk until finally they dump their holdings at any price they can get. They’ve created a dangerous situation for themselves (by not cutting losses or taking too much initial risk) that spirals out of control against them. Most investors can stomach a 10% loss without too much grief, but when they start losing multiples of that, primitive survival instincts awaken to life. Fear sets in. Our highly developed survival instincts which may or may not be attuned to our financial survival tell us to take flight. We get rid of the situation by selling in a panic. It is human nature.

 

This is why technical analysis is so essential to investing. Not only does it track the human element, but more importantly it allows you to create trades where you decide the amount you risk and the cut-off point where a good investment decision has turned sour. There are many technical setups that offer several percentage points of upside with only very limited downside risk, sometimes as low as one percent or less. These scenarios present themselves at various times to the astute investor, who in his/her research and analysis notes these situations as they develop, watches them, comprehends when they are confirmed or rejected, and arrives at an investment decision based on either outcome.

 

With many stocks plunging well into the double-digit losses over the last two weeks, and the Dow down over 600 points today alone, you can see why it is important to establish technical levels that would indicate your judgment is incorrect. By timing investments to include a max percentage loss before the trade is established an investor can avoid situations like being stuck in the middle of the market decline we’ve been experiencing. A good rule of thumb is to lose no more than 10% on a single investment, but depending on the volatility of the issue and your own risk tolerance, you may determine a level that is most suitable for you – whether it be more or less than 10%.

 

The take-away is to preserve your earning power. Preserve your sanity. Defend yourself and you will live to fight another day.

 

 

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